Principle #7: Understand the Difference between Value & Price

“Buy Low, Sell High” is likely the most common of all investing adages. The implication, of course, is to purchase an asset (e.g., shares of companies) and sell it to someone else for a higher price. This is difficult to achieve since lows and highs in price only become clear in retrospect.

In the equity markets, the “buy low, sell high” objective causes most investors to focus on the price of a stock when their attention should really be on its value. By focusing on price, investors forget that a stock is not just a piece of paper to be traded by one person to another. Rather, a stock represents a share of a business that works every day to make money.

So what’s the difference between the price versus the value of a company share (stock)?

For publicly traded companies, price discovery occurs every business day on the stock exchange. Investors “vote” with their wallets by buying and selling company shares in an efficient marketplace. The price of a share is simply the last traded price. It is driven by a combination of financial analysis, investor psychology, media reporting and a variety of reasonable (and sometimes unreasonable) market and economic sentiments. Prices of shares fluctuate on a minute-by-minute basis, often without any material changes to the performance and value of the underlying company.

Short term price fluctuations do not reflect changes in value.

The most widely accepted definition of value of a financial asset is its future cash flows discounted back to today at an interest rate that compensates for time and risk (of permanent loss).

Let’s illustrate this with the following example.

Assume you have a machine that magically provides you with $1 every year (forever). In order to compute its value, you assume that future dollars will be discounted by 10% per year (to compensate for risk of the machine breaking down, being lost and also the loss of buying power of future dollars due to inflation). In this case, the machine would be worth $1 (for this year’s dollar) plus $0.90 ($1 less 10%) for next year plus $0.81 ($1 less 10% less another 10% ) for the year after that, and so on …..

Value of Machine = $1.00 + $0.90 + $0.81 + $0.73 + $.066 + …..

While determining the future cash flows of a business is somewhat more challenging, determining the value of a share can follow a similar approach.

Only through a clear insight on the disparity between value and price of a share can an investor have the conviction to consistently buy low and sell high. If you only know the price of what you’re buying and selling and not the value, it is impossible to be a successful investor.